Sponsor:
Marco Celentani acknowledges the financial support of MCYT (Spain) under project PB98-00024. José-Ignacio Conde-Ruiz acknowledges the financial support of MECD (Spain) under project EX200l-02885993E. Klaus Desmet acknowledges the financial support of the Commission for Cultural Educational and Scienlific Exchange between
the United States of America and Spain (Project 7-42) and the Comunidad de Madrid (Project 06/O064/2000).

Abstract:

We analyze risk sharing and fiscal spending in a two-region model with complete markets. Fiscal policy is determined by majority voting. When policy setting is decentralized, regions choose pro-cyclical fiscal spending in an attempt to manipulate securities prices to their benefit. This leads to incomplete risk sharing, despite the existence of complete markets and the absence of aggregate risk. When a fiscal union centralizes fiscal policy, securities prices can no longer be manipulated and complete risk sharing ensues. If regions are homogeneous, median income residents of both regions prefer the fiscal union. If they are heterogeneous, the median resident of the rich region prefers the decentralized setting